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Forecasting The Market: A Thought Experiment.

  • Written by Syndicated Publisher No Comments Comments
    September 2, 2011

    At the beginning of September with 99% of Q2 earnings reported, here is the latest update of my ongoing “thought experiment” for forecasting the S&P 500 price based on earnings fundamentals.

    The chart below is based on the latest trailing twelve-month earnings (TTM) data published on the Standard & Poor’s website as of August 31. The numbers are from the spreadsheet maintained by senior analyst Howard Silverblatt. See dshort’smonthly valuation update for instructions on downloading the spreadsheet.

    Here are the key assumptions in the calculations:

    • The 10-year average of nominal TTM earnings is 50.41 at the end of 2010, rising to 53.66by the end of the year.
    • The average nominal cyclical P/E10 is currently 18.10.
    • The S&P 500 historic prices used in the calculations are monthly averages of daily closes.
    • Standard & Poor’s estimates of TTM earnings for Q3 2011 through Q2 2012 are
      $87.81, $88.68, $91.04, and $93.75 (as of the August 31 spreadsheet).
    • The months between the quarterly earnings estimates are linear interpolations.

    The blue line represents Standard & Poor’s TTM forecast earnings by month multiplied by the historical nominal 10-year P/E ratio. At 2011 year-end earnings of 88.68 and an average nominal P/E of 18.10, we would see the S&P 500 at 1605. At this level, the nominal P/E10 would be 30.10, and the index would be 65.2% above a hypothetical price multiple of the extrapolated 10-year earnings average.

    The red line represents a hypothetical S&P 500 price that is a multiple of the average nominal P/E10 of 18.10 and the 10-year average earnings of 50.41 for December 2010. The monthly index price estimates thereafter are linear extrapolations based on average 10-year earnings growth.

    The optimistic view (blue line) would put us around 1605 in the S&P 500 by December, the assumptions being that the Standard & Poor’s earnings forecasts are correct the nominal P/E10 ratio is the multiple we see.

    The pessimistic view (red line) is a reversion to the historic earnings and nominal P/E10 multiple.

    But history shows us that, regardless of your preferred earnings divisor (nominal or real, TTM or 10-year average TTM), the P/E ratio has never hovered around the average. The market swings above and below its long-term average valuation in erratic arcs that can last for many years. For a long-term perspective on valuation extremes, see Four Market Valuation Indicators and the compelling research ofEd Easterling on the history of earnings per share.

    I’ll revisit this chart periodically throughout the year.

    Note from dshort: For an interesting comparison, here is Chris’s chart from last month, based on the then current Standard & Poor’s spreadsheet.

    From  Forecasting the Market: A Thought Experiment Revisited.

    Images: Flickr (licence attribution)

    About The Author

    My original dshort.com website was launched in February 2005 using a domain name based on my real name, Doug Short. I’m a formerly retired first wave boomer with a Ph.D. in English from Duke. Now my website has been acquired byAdvisor Perspectives, where I have been appointed the Vice President of Research.

    My first career was a faculty position at North Carolina State University, where I achieved the rank of Full Professor in 1983. During the early ’80s I got hooked on academic uses of microcomputers for research and instruction. In 1983, I co-directed the Sixth International Conference on Computers and the Humanities. An IBM executive who attended the conference made me a job offer I couldn’t refuse.

    Thus began my new career as a Higher Education Consultant for IBM — an ambassador for Information Technology to major universities around the country. After 12 years with Big Blue, I grew tired of the constant travel and left for a series of IT management positions in the Research Triangle area of North Carolina. I concluded my IT career managing the group responsible for email and research databases at GlaxoSmithKline until my retirement in 2006.

    Contrary to what many visitors assume based on my last name, I’m not a bearish short seller. It’s true that some of my content has been a bit pessimistic in recent years. But I believe this is a result of economic realities and not a personal bias. For the record, my efforts to educate others about bear markets date from November 2007, as this Motley Fool article attests.